Fair Value Accounting — It Is What It Is

I’ve written on mark-to-market accounting before.  Searching my blog, I was surprised to find how many pieces I have written in 2008 on the topic.

So, it’s interesting to me to see the FASB interested in continuing with Fair Value accounting, despite all of the criticism.  It’s not to say that MTM accounting is perfect — all accounting methods are approximations and are imperfect, but does it convey the best information needed for investors to make  reasonable decisions, at an acceptable cost?

If MTM accounting were proposed in the ’80s it would never have been approved.  The value of common financial instruments did not usually change much; unless an equity had a public market, revaluations occurred only for reasons of impairment.  But derivatives and structured security prices vary considerably, and their prices often vary in a way that approximate valuations can be calculated from the prices of other publicly traded securities.

Now, that many financial companies trade below their net worth is a proof in this environment that investors don’t trust the value of the assets, nor their earning power.   Many assets have not been marked down to their fair value.

I will defend SFAS 157, and the other mark-to-market accounting standards, but I won’t defend an application of them that is too rigid.  When trades are infrequent, and there are strong reasons why the security deserves a different value than last trade, then let the security be marked to model.  It is the best that can be done.  But merely that a security is at an unrealized loss for several years should not in itself be a reason to mark the security down, if the management concluded that it was “money good.” (they get their principal back.)

The mark-to-market rules as stated have flexibility in them, aiming for a fair statement of the net worth of the firm.  Given the nature of the investments and hedges employed, this is a good thing if done properly and fairly.

Can these rules be used to distort accounting?  Of course, in the short run.  In the intermediate-term, the errors catch up, and destroy the cheater.  In the long run, cash flows determine the value of a business.

So, be wary in the present environment.  Just because a financial institution trades below book value does not mean that it is cheap.  Much of the cheapness stems from the opaqueness in pricing of unique risks.

The challenge is analyzing what an asset is truly worth, and when that value can be realized.  That is the challenge with financials today.